Brazil’s Volatile Real: Why Currency Fluctuations Are Painful

Brazil’s volatile currency, the real, is back in the news. Two years ago, the real hit all-time highs against the dollar. The rise prompted Brazil’s finance minister, Guido Mantega, to accuse the central banks of advanced countries, the Fed in particular, of conducting a “currency war” at his country’s expense. Now the real is heading back toward the lows it reached in 2008, at the depth of the global financial crisis. One might think that if a strong real is bad, then a weak real must be good, but that has not been the reaction. Instead, the recent depreciation has caused Brazil’s central bank president to complain about the “adverse winds” from a strong dollar.

Why are currency fluctuations, regardless of direction, so painful, and not just for Brazil? The traditional notion is that exchange rate movements, whether appreciation or depreciation, produce roughly equal gains and losses. Some of them come from the effects on trade in goods and services. When a country’s currency appreciates, its exporters find it harder to sell their products abroad and domestic producers have a harder time competing with imports. They are losers. Meanwhile, firms that use imported inputs and consumers of imported goods are winners. There are also financial effects. People whose foreign currency assets exceed their foreign currency liabilities gain from appreciation of the domestic currency, and those with foreign currency liabilities greater than foreign currency assets lose.

Despite all the headlines that focus on the relationship of the real to the dollar, the gains and losses from currency volatility do not depend solely on any one bilateral nominal exchange rate. We can get a broader perspective by looking at a country’s real effective exchange rate, which includes adjustments both for the differences in rates of inflation in different countries, and for the relative importance of various trading partners. In this case, inflation in Brazil has run between 4 and 7 percent since 2008, much higher than the 1 to 2 percent inflation in the United States and higher than most other trading partners as well. Also, the United States accounts for just 19 percent of Brazil’s trade, less than the 21 percent of the eurozone and only a little more than the 14 percent of China.